Meet the Street: Know When to Hold 'Em and When to Fold 'Em

The end of the year is always a good time to take stock -- no pun intended -- of your investments and decide what's worth keeping and what isn't.

Unfortunately, selling stocks and funds can be very difficult for many investors, especially when it means realizing a loss. But selling poorly performing investments, taking tax losses on them and reinvesting the proceeds in better-performing vehicles is an essential part of building a successful portfolio.

To get some thoughts on how to surmount the psychological obstacles to selling losing investments, as well as strategies for discerning what to keep and what to toss, we spoke to Don Cassidy, senior research analyst at fund tracker Lipper. Cassidy is the author of five books on investing, including his latest, It's When You Sell That Counts, which identifies reasons investors can be reluctant to sell their investments, and offers advice on how to overcome them.

TSC: Why do some people find it so hard to sell losing investments?

Cassidy: People have tremendous problems with selling, win or lose, but especially when they have losses. A loss attacks the ego. We prefer to put it out of sight rather than deal with it. Actually finalizing the loss makes it "official" -- like a final grade we had the power to avoid by somehow magically keeping the semester open. We don't like feeling dumb. And, we have that nagging suspicion that the market may be out to get us -- see your therapist for common paranoia and/or psychosis -- and will rally the minute we sell.

The reality is that the market sees each of us as ants and really doesn't think about us at all. We really need to get our egos out of it. Just because you bought a stock once does not mean it will come back. History says that 95% of Internet companies, a major new technology, will go belly up. Remember, there were once 130 U.S. car manufacturers.

Don Cassidy, Senior Analyst, Lipper

Recent Meet the Streets

Vanguard's Jack Bogle

Cadwalader, Wickersham & Taft's Robert C. Lawrence

Prudential Securities' James Lucier

Scudder Emerging Markets Income Fund's Jan Faller

Ernst & Young's Desmond Wong

Stop hoping against hope with the awful-looking Internet stocks. The charts tell the story, and the recession will surely hurry the death process. You might well be correct to bet that an Internet fund may never recover to its old highs in your lifetime. Grim but probable. Sorry.

TSC: How can investors get over this mentality?

Cassidy: One way to detach the ego is to pretend we have all cash -- maybe the broker or fund company made a terrible electronic mistake -- and we have to decide what to buy all over again. Of the thousands of stocks/funds we have to choose from, the odds are slim we will choose exactly our old list if we have a fresh choice.

Holding an investment is simply buying again for tomorrow/next year what we happen to own today. Asset-allocation decisions should be made deliberately, not due to the baggage of inertia and ego. Admittedly this is hard in cold-cash terms when there is a big gain and thus a tax to pay. But with a loss, what is the problem? Ego. So take that refund check now.

TSC: Should investors consider selling funds in order to claim tax losses?

Cassidy: Especially in funds -- where few are as unique or totally different as are individual stocks -- when you have a tax loss, why not take it? If you are afraid to miss a rally, buy an equivalent fund the same day you sell (technology for technology, etc.) and you will have a choice of some that have done better lately than your old one.

The only area to be careful of is wash sales in S&P 500 index funds. If the two funds are identical, you have to wait 31 days, or buy 31+ days before you sell, and that choice is now gone in 2001 as there are only a couple of weeks left.

TSC: What can investors do with those tax losses once they've been claimed?

Cassidy: One thing that selling a losing fund/stock will do is to possibly free up some other big winner that you feel as though you "can't sell" because of the gain. Taking a loss now on A allows you to slice off some of B (that old J&J or Merck or GE or Wal-Mart you own for dimes on the present dollar). Match the loss amount to take equal available gains. That will allow you to pare back what has been a real winner but now may be a dangerously large holding. If you really must own as much as you do, buy the winner back immediately then (there is no wash-sale rule on gains).

Also, the freeing up of cash from a losing position gives you the freedom to do some proactive asset reallocating. Use the rule of 110: subtract your age from 110 and the result is the minimum percentage you should have in stocks and equity funds. If you are above that declining-sloped line (as many were in early 2000), buy bond funds or money market funds. If you are below, as many now are because of the bear's claws' damage, you need to buy equity funds. Yes, it may be scary, and that is in itself a good sign you are doing the right thing.

Once it becomes comfortable to buy again, the market will already be high! So always move towards discomfort. Comfort develops only late in a directional move, not early.

TSC: How should fund investors decide which investments to sell?

Cassidy: One suggestion is this exercise: Pretend you absolutely must sell $X thousand worth of assets in the next 30 days to meet a big medical or tuition bill. You have no cash and only stocks/funds. Look carefully at each holding and decide which you think have the best vs. worst prospects from today -- not what you originally hoped for. Then look for a little rally and sell the weaker links in the group.

You will likely not prove 100% correct. There is no way to do that. You just do your best. And the exercise of selling and moving on will be good: it will loosen you up a little for future decisions. And noticing that life went on despite your imperfection will be healthy, too.

Another reason people hate to sell is that doing so usually (ex the scenario just above) forces on them yet a second choice under uncertainty: What to buy. People outside our professions don't love this stuff; they hate it. Making decisions under uncertainty is highly stressful. And that's the exact description of the markets -- constant uncertainty. Watching financial TV makes it all the more vivid, so turn it off for a while and find a quiet place to think for yourself.

TSC: Any other advice?

Cassidy: Whether it is after the 401(k) and Dec. 31 brokerage/funds statements arrive or before the year ends, you must discipline yourself not to move to comfort by selling all your losers in frustration.

There is a great current temptation to flee stocks/equity funds which have hurt us and go to cash or bonds. History shows that only twice in the 20th century did the DJIA decline for three calendar years running: 1901-03 (and 1902 was down a mere 0.4%!) -- and 1929-32, which was the start of the Great Depression.

If you don't expect a depression, hold and/or buy stocks; don't sell after a two-year fall! This history, plus personal application of the rule of 110, should shape your decision. The pain has been long and deep, especially for recent entrants who have never seen or expected a bear market. History says stocks fall three years in 10. Bull markets always start when the news is dark and we are still in a recession. Does that sound a lot like late 2001?